Volume 23, Number 5 February 2007

Subprime Lending Lessons from the Ameriquest Settlement Joseph E. Mayk

Joseph E. Mayk is of counsel s has been widely reported, early last above the comparable treasury security yield). in the consumer financial year Ameriquest Mortgage Company The oral disclosures, which are in addition to services/retail banking practice and related companies settled a multi- already existing Truth-in-Lending Act (TILA), group of Blank Rome LLP. A state investigation over certain allegedly decep- Real Estate Settlement Procedures Act (RESPA), He is resident in the firm’s Philadelphia office, where his tive consumer lending practices. The settlement and other mandated written disclosures, cover practice focuses on advising included $295 million to repay borrowers with the key loan terms, such as the repayment term, lenders on all aspects of loans originated between January 1, 1999 and interest rate, monthly payment, existence of a pre- consumer finance regulato- December 31, 2005, plus $30 million to pay for payment penalty, whether amounts are escrowed, ry compliance. Mr. Mayk 1 can be reached at mayk@ the investigations. amount and effect of any discount points, and blankrome.com. Like Household Finance Corporation’s nearly adjustable rate disclosures for adjustable rate mort- $500 million settlement with the states in 2002, and gages (ARMs). If the application is not submitted to a lesser extent ’s $215 million and $70 orally, the substance of the oral disclosures must be million settlements with the Federal Trade Com- provided in writing within three days of receiving mission and the Board (which the application. did not explicitly require as many changes to Significantly, instead of imposing general require- Citi’s lending practices), the Ameriquest settlement ments, the settlement agreement provides scripted represents another mile marker in an emerging language for these disclosures, which Ameriquest “best practices” road map for subprime consumer must use, or alternative language that is substan- mortgage lending. As such, lenders are well advised tially similar. Over the years, lenders have had to compare the terms of this settlement to their different views on the utility of scripted oral current practices. The purpose of this article is to disclosures. While some have found them to be highlight certain terms of the settlement and sug- impractical or too restrictive to the sales process, gest issues that lenders may wish to consider with other lenders have seen the value in oral scripts respect to their own consumer mortgage lending (especially when coupled with listening programs) programs. Keep in mind, however, that no new in helping to ensure consistency in the sales proc- requirement imposed on Ameriquest is required ess, as well as in reducing the risk of deceptive of any other lender (at least not yet). sales claims. In addition to the specific scripted oral disclo- ORAL DISCLOSURES sures, the settlement agreement contains a number The settlement requires a number of oral disclo- of negative covenants that prohibit Ameriquest sures for “Non-Prime loans” (defined as first lien employees from making potentially misleading loans where the APR is equal to or greater than statements. For instance, Ameriquest cannot rep- two and a half percentage points above the yield resent that its interest rate or terms are “better,” for a treasury security of comparable maturity “lower” than, or “competitive” with those of and, for junior lien loans, five percentage points other lenders, unless the representations are, in Lessons from the Ameriquest Settlement fact, true. The Household settlement also contained a number a decrease in the loan amount greater than one percent; the of provisions prohibiting Household from making misleading addition of a prepayment penalty; or a change from a fixed rate representations. to an adjustable rate loan. These are obviously prudent policies for lenders to have in The concept of redisclosure is currently the subject of place. While scripts can be very helpful in protecting a lender much discussion in the mortgage industry. For instance, it from claims of misrepresentation, it is also important that loan is expected that any RESPA reform on the horizon will officers and others understand that statements should not be deal with redisclosure of the good faith estimate if there is a made which contradict, undermine or obscure the more spe- change in the terms beyond some sort of tolerance. cific disclosures. The concept of redisclosure here seems to make sense, espe- cially for any lender that chooses to provide an early disclosure WRITTEN DISCLOSURE OF of material loan terms that is not otherwise required by state or LOAN TERMS federal law. For instance, if a lender provides an early disclosure The settlement also requires Ameriquest to provide consum- of material loan terms, it would not want to face a bait and ers with a single page disclosure of the key loan terms within switch claim if the final loan terms are different. Timely redis- three days after obtaining loan pricing information (but in closure helps protect against such a claim. no event later than three days after when an appraisal or loan documents have been ordered). This requirement applies to all LOAN PRICING loans, and not just non-prime loans. The form of written dis- Ameriquest must use a pricing model for loans that is designed closure contains information similar to that which Ameriquest to produce (before application of any price exception) the same is required to provide in the oral disclosures for non-prime interest rate and number of discount points for all potential loans. Household was also required by the regulators to imple- borrowers with the same credit risk characteristics and who are ment a one page summary of key loan terms. the same with respect to any other material characteristics (e.g., A clear, concise, written disclosure of key loan terms is loan-to-value ratio, type of property, etc). This part of the settle- another tool that can help protect lenders from deceptive sales ment commits Ameriquest to maintaining a policy that it vol- claims. Disclosures required by RESPA and TILA have been in untarily instituted in 2003 as part of a “best practices” initiative. effect for many years now, but are often insufficient to protect A “price exception” is defined as the offering of a rate that is a lender from misrepresentation claims even when properly lower than the rate for which the borrower otherwise qualifies given. In fact, there is a wide consensus among both lenders under the pricing model. To make sure that the use of price and consumer advocates that the current federal disclosures are exceptions is not undermining the pricing model, the settle- unnecessarily confusing to consumers. Of course, any lender ment provides that if in any ninety day period the number of considering a simplified summary disclosure must ensure that borrowers receiving a price exception exceeds thirty percent of it is consistent with the disclosures required by state and federal the loans originated during that period, there will be a rebuttable law. presumption that Ameriquest has violated this part of the settle- ment agreement. However, the term “price exception” does not REDISCLOSURE include a price reduction that is necessary to keep a loan below Another key component of the settlement is a requirement to federal and state “high cost” loan triggers or price reductions in give a new written summary disclosure if there is a “material certain other limited circumstances. Thus, loans where pricing is change” in the loan terms. The new disclosure must be mailed reduced in such cases do not count against the 30 percent cap. no less than six days before closing or otherwise delivered or This part of the settlement, along with restrictions on employee made available to the consumer at least three days before clos- compensation discussed below, would seem to eliminate the use ing for a non-prime refinance loan or one day before closing of overage pricing by Ameriquest. This is just the latest sign that for all other loans. overage compensation programs are receiving increased scru- A change is “material” if there is an increase in the interest tiny from regulators and the secondary market. New York, for rate of 30 basis points or more, or any increase in discount example, has for the past few years required lenders to describe points other than as a result of the trading of discount points their policy on overages.2 The secondary market has also gotten for an interest rate reduction that is affirmatively requested by more active in regulating the amount of points that can be the borrower; any increase in the repayment term of the loan; charged in a transaction For instance, Fannie Mae and Freddie

2 REAL ESTATE FINANCE FEBRUARY 2007 Subprime Lending Lessons from the Ameriquest Settlement

Mac generally limit the total points and fees to 5 percent of financial interest in the loan being closed other than payment the loan amount. Many private investors impose similar restric- of standard settlement fees. tions. The public scrutiny of pricing data now captured by Each independent loan closer must be given written instruc- HMDA has further highlighted the potential fair lending risk. tions on the closing and must provide a written report to Lenders engaged in discretionary pricing need to seriously Ameriquest senior management if the loan closer discovers consider the benefits and risks of continuing to do so, and, at any unfair, deceptive, misleading or unlawful behavior by any a minimum, should put policies in place (such as back-end Ameriquest employee in connection with the loan. Further, closed loan reviews and front-end listening) to minimize the Ameriquest employees are only permitted to attend non-prime risk that pricing is creating a fair lending issue. closings if requested by the borrower. The instructions given to the loan closer must require the closer to fully explain the BORROWER BENEFIT closing process and the loan documents, and prohibit the closer Ameriquest is also prohibited from entering into any non- from pressuring or rushing the borrower, including by suggest- prime refinance loan that does not “provide a benefit” to the ing that the borrower can use the TILA rescission period to borrower and must document how each such loan provides a read the loan documents. borrower benefit. Unlike the federal Home Ownership and This part of the settlement agreement is an example of good, Equity Protection Act (HOEPA) and some state high cost common sense closing practices. While it is unlikely that your lending laws, there is no time limit on the refinancing. Thus, “independent” loan closer will have sufficient recollection of it appears that Ameriquest must perform this borrower benefit a particular transaction in the event there is ever a problem, test in every non-prime refinance transaction, regardless of having policies that show a sensitivity to these issues can only when the refinance occurs in relation to the making of the help a lender’s case. original loan. Note also that the definition of a “non-prime” loan (APR that is two and one half percentage points for first LOAN FUNDING lien loans and five percentage points for subordinate lien loans Ameriquest is required to disburse the funds on all refinance over the comparable treasury security yields) will capture many loans on the first business day after the expiration of any rescis- loans that are subject to neither HOEPA nor state high cost sion period. However, the settlement agreement also acknowl- loan laws. edges that Ameriquest need not disburse the proceeds of any While this provision is unique to Ameriquest and the par- loan until it is “reasonably satisfied” that the borrower has not ticular dictates of the settlement, it should be noted that the rescinded the transaction, as required by Regulation Z to TILA. concept of “suitability” is becoming more prevalent in the This highlights an often overlooked issue under Regulation mortgage industry. For instance, with the exception of certain Z. The Commentary to Regulation Z gives examples of how prime loans, requires that a “borrower’s interest” a lender can satisfy itself that the consumer has not rescinded test be run on any consumer mortgage that refinances another (i.e., by waiting a reasonable time after expiration of the consumer mortgage made within the prior sixty months.3 rescission period to allow for delivery of a mailed notice by On a related point, Ameriquest is prohibited from solicit- the consumer or obtaining a written statement from the con- ing borrowers with existing non-prime loans for refinanc- sumer that the right has not been exercised).4 While these are ing within the first 24 months unless: Ameriquest receives a not the exclusive means of confirming that a consumer has request for a pay-off statement; is contacted by a borrower who not chosen to rescind, they highlight the fact that a lender is inquires about refinancing; or otherwise has a good faith belief prohibited from disbursing funds until it is reasonably satisfied that the borrower is considering refinancing. In any case, the that the consumer has not rescinded.5 This is a requirement refinancing must still provide a benefit to the borrower. that is often overlooked by many lenders that simply disburse immediately upon the expiration of the rescission period, INDEPENDENT LOAN CLOSERS; without attempting to confirm that the consumer has not WHISTLEBLOWING elected to rescind. Ameriquest is required to use “independent” loan closers for the closing of all non-prime loans. A loan closer is “independ- APPRAISALS ent” if he is not an employee of the branch office where the The settlement also establishes a very detailed program loan is originated or a relative of such an employee, and has no dealing with the independence of the appraisal function; in

FEBRUARY 2007 REAL ESTATE FINANCE 3 Subprime Lending Lessons from the Ameriquest Settlement

particular, in ensuring that the branches play the smallest role mine that the amount of stated income is appropriate for the possible in the appraisal process. This is achieved by the creation occupation and experience claimed. For instance, if the stated of a panel of qualified, approved appraisers for each state. When income is based on self-employment or a home-based busi- a file is opened, an automated system assigns the appraisal to ness, Ameriquest must request evidence of the existence of an appraiser based on an algorithm that is designed to limit the the business. discretion of Ameriquest employees. To be selected for a panel, As stated income loans have become increasingly available the appraiser must be in good standing with his or her state in the subprime market over the past few years, these would licensing authority and must have had their past work product appear to be prudent underwriting practices for subprime audited for quality and compliance if they have previously lenders to implement. Remember also that stated income done appraisals for Ameriquest. loans are effectively prohibited for loans that meet the Perhaps most significant, Ameriquest is required to comply with HOEPA triggers. When the Fed amended the HOEPA regu- the October 28, 2003, guidance issued by the federal banking lations back in 2002, it created a presumption that HOEPA agencies, which stresses the need for independent appraisal and is violated when a lender engages in a pattern or practice of evaluation functions.6 Significantly, an Ameriquest affiliate, Argent making “high cost” loans without documenting and verifying Mortgage, entered into a Cease and Desist order with the state repayment ability.8 of in September 2005, under which it was essentially required to follow a 2003 White Paper on detecting and deter- COMPENSATION PROGRAMS ring (including appraisal-driven fraud) issued by With respect to employee compensation, Ameriquest can- the Federal Financial Institutions Examination Council. not provide incentives to encourage its employees to include Given these developments, lenders would be wise to familiar- a prepayment penalty, quote a borrower an interest rate that is ize themselves with the existing federal banking standards on inconsistent with the “same rate available” provision discussed appraisals and property evaluations, subjects on which state law previously, or otherwise increase compensation based on loan is largely silent. Since at least the early 1990s, the federal banking fees or closing costs. agencies have established regulations and guidelines on a variety As with the “same rate available” settlement provision, this pro- of appraisal and evaluation issues (e.g., independence, licensing vision highlights the growing sensitivity toward overage policies versus certification, appraisals versus property evaluations, etc.).7 and other methods of compensating loan officers based on inter- STATED INCOME LOANS est rates, points or other fees obtained above a certain level. This part of the settlement prohibits Ameriquest employees CONCLUSION from inflating or fabricating the source or amount of a bor- The Ameriquest settlement is only the latest (and likely not the rower’s actual income, or encouraging a potential borrower to last) salvo in the “regulation by investigation” campaign launched do so. In addition, the independent loan closers are required to by state banking departments and attorneys general over the last have the borrower sign a statement at closing certifying that: several years. High profile, high dollar settlements like this, the Household and Citi settlements and the Fairbanks settlement in a. The borrower understands that the loan has been the servicing area effectively create an additional layer of practices approved based on the amount of income reported by the for lenders and servicers to seriously consider, since the terms of borrower, the settlements often go beyond the specific requirements of exist- b. The amount of income reported is accurate, ing statutes and regulations governing the mortgage business. c. If the borrower’s actual income is less than the amount In many instances there is no allegation of a violation of set forth in the application, the borrower understands that any specific mortgage lending law (such as the charging of there is a significant risk that the borrower will not be able an impermissible fee or the failure to give a required dis- to afford the loan, and closure) that underlies the investigation. Instead, the inves- d. That any false statements may subject the borrower to tigations are often premised on more general allegations of criminal penalties. unfair or deceptive conduct. The inherent elasticity of such a claim makes it difficult for lenders to see the boundaries. The settlement also requires Ameriquest to employ a rea- These types of settlements, for good or ill, bring those sonableness standard in its underwriting guidelines to deter- boundaries into clearer focus.

4 REAL ESTATE FINANCE FEBRUARY 2007 Subprime Lending Lessons from the Ameriquest Settlement

It is important to understand that these settlements are not settlement terms to your current lending programs, disclosure aberrations. The state attorneys general, in particular, have practices, pricing and compensation policies, etc. will go a become increasingly active in multi-state investigations of long way toward letting you know whether you may soon various industries. The subprime mortgage lending business find yourself in the regulators’ crosshairs. will likely continue to be a focus of attention, especially as the market continues to be roiled by a spike in foreclosures, NOTES 1. The settlement agreement is publicly available and can be found on most state attorney early payment defaults, and the attendant negative publicity. general and department of banking Web sites. The federal banking agencies’ nontraditional mortgage 2. See N.Y. Comp. Codes R. & Regs. tit. 410, §§ 410.8(g), 410.8(h). 3. See Mass. Gen. Laws ch. 183, § 28C; see also 209 Mass. Code Regs. 53.00, et seq. guidance, with its focus on appropriate consumer disclosure 4. See Official Staff Commentary, 226.23(c)-4; Official Staff Commentary, 226.15(c)-5. 5. See 12 C.F.R. § 226.23(c); 12 C.F.R. § 226.15(c). of the risks and benefits, will likely provide another avenue 6. See, e.g., OCC Advisory Letter 2003-9 (Oct. 28, 2003). of investigation for state regulators, as numerous states have 7. See, e.g., 12 C.F.R. §§ 34.41–34.47 (Jun. 7, 1994); Interagency Appraisal and Evaluation Guidelines, SR 94-55 (Oct. 28, 1994); OCC Bulletin 2005-6, Frequently Asked Questions adopted the federal guidance. on Appraisal Regulations, the Interagency Appraisal and Evaluation Guidelines, and OCC Advisory Letter 2003-9 (Mar. 22, 2005). For now, lenders should use these settlements as a way to 8. See 12 C.F.R. § 226.34(a)(4). gauge their potential exposure. A simple comparison of the

Reprinted from Real Estate Finance February 2007, Volume 23, Number 5, pages 21-25, with permission from Aspen Publishers, Inc., Wolters Kluwer Law & Business, New York, NY, 1-800-638-8437, www.aspenpublishers.com

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